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Question. When my wife died several years ago, I sold the large house we were living in and bought a smaller house.. That purchase was at the top of the local real estate market. I have just purchased a retirement home and would like to sell my current property. However, after real estate commissions and sales expenses, I am facing a sizable loss -- and my accountant tells me this loss is not tax deductible. Can you suggest any solutions so that I do not lose my long-term investment?

Answer. Your accountant is correct. Current tax law permits a tax loss deduction for investment property but not for a principal residence. Although it appears that some day in the foreseeable future Congress will provide similar tax relief for the American Homeowner, at present no such laws are on the books. In fact, the current Congress appears intent on reducing homeowner rights and benefits.

You do, however, have a few options.

First, to the extent you can make projections, try to analyze the future marketability of your house. Will the house come back up in value, or will it continue to deteriorate? If you keep the house for a longer period of time, will you have to make a number of costly repairs and thus be throwing good money after bad? In other words, does it make sense to "take your loss and run?"

Second, if you decide it makes sense not to sell now, rent the house out for a year or two. Abandon the house as your principal residence; pay taxes where your retirement home is located, get a new driver's license and new voter registration card at a different address. Let your friends and relatives know that you no longer call that property your "home."

A year or two from now, depending on your financial and personal needs, you can then sell the property. Since it will then be investment real estate, you may be able to deduct some of your tax loss on your income tax return (although you should confirm the amount with your accountant).

If you do not need the money -- or the tax loss -- and if the rental income from the house is worthwhile, you can continue to rent out the house.

Third, once you have converted the property to that of an investment (rather than your principal residence), you might want to consider swapping the house under the "like-kind" (Starker) exchange. Such an exchange would permit you to obtain alternative real estate, without currently having to pay tax on any profit. Obviously, however, if you have no gain, there is no need to consider a Starker exchange. The rules for such an exchange are complex, and have been discussed in earlier columns.

Finally, if you have children, why not consider keeping the real estate until your death. Under current tax law, (which may change in the current Congress) your children will inherit the property at what is known as the "stepped-up" basis. Oversimplified, this means that the children's tax basis is the value of the property at the date of your death -- and not your tax basis. Your tax advisors should be asked to analyze all of these various options.

Your question also raised a very important issue facing many older homeowners-- and one that is often overlooked or forgotten. Many homeowners purchased their first home many years ago at low prices. Over the years -- especially in the l970s and l980s -- real estate appreciated rapidly. Many homeowners moved from one house to another, and took advantage of the roll-over. Now, when they want to sell their last house -- or purchase down in price as you are considering -- the tax issues become very important.

Let us look at the following example. Assume that in 1970, you and your wife purchased your first house for $30,000. Over the years, you added $20,000 in improvements, and thus the basis for tax purposes (purchase price plus improvements) for you and your wife was $25,000 each. In 1987, you sold the house for $200,000, thus generating what you probably believed was a paper profit of $150,000.

However, since your wife died before you sold the first house, your basis is increased by virtue of the "stepped up" basis. At the time of your wife's death, the property was worth $200,000. Under the tax laws, you inherited your wife's basis as of the date of her death; in our example, her basis was $100,000. Thus, for tax purposes, the basis of your first house when you sold it was $125,000 ($25,000 plus $100,000).

Your house was sold for $200,000, and thus your profit was $75,000. But since you purchased your current house within two years from the time the first house was sold, you qualified for the roll-over, and this profit was used to reduce the basis of the Alexandria house. Accordingly, although you paid $300,000 for the new property, in reality its basis is $225,000.

If you sell the house now for $220,000, even after paying real estate commissions and other expenses, your paper loss will not be as great as you think.

However, this is tax talk; you are looking at an actual loss of $80,000, since you purchased the house at $300,000 and now can only sell it for $220,000. There are a lot of people who purchased real estate at the peak of the market, -- and despite significant increases in value -- many homeowners are still unfortunately under water.

And the rollover has long been replaced by the up-to-$250,000/$500,000 exclusion of gain.

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